The first trade reform

India needs to fix its connections to global supply chains, by investing in logistics and trade facilitation

My earlier piece of May 19 on trade reforms that India urgently needs, to address its rising CAD and restoration to a high growth trajectory, emphasised three things: connecting India's manufacturing to regional and global supply chains to drive exports and employment; diversification of professional services beyond IT and IT-ES to widen export earnings from services; and a focused regionalism to gain a much wider market access.

The high transaction costs of producing and trading across borders have meant that Indian manufacturing historically operates largely outside the global system of production networks. It remains one of the least integrated of emerging economies. The graphic clearly shows that foreign content in final exports, a good proxy for capturing the level of integration in global supply chains, is just 18 per cent in India compared to over 30 per cent in other emerging countries. It is interesting to note that the percentage of foreign content in exports from special zones in China and Mexico (labelled 'processing') is so much higher than their exports from outside the zones.

Modern and effective zones and innovative clusters were created in these countries to better integrate into the global supply chains, largely financed through FDI. Unfortunately, India's attempts with government-controlled SEZs are completely out of line with these modern concepts of zones and clusters. (Click for chart)

Global supply chains that define such production networks need to be cost effective, time bound and certain. None of which can be guaranteed in Indian conditions with poorly designed and implemented regulations combined with inadequate infrastructure. The integration of Indian SMEs, which have great potential, into such global networks, is especially held back due to such high transaction costs; larger Indian firms are more able to surmount the difficulties posed by working in the Indian environment and credibly signal their ability to do so. Thus, any government that seeks to champion the cause of SMEs, and the growth of employment in manufacturing through export development cannot but take the issue of transaction costs and trade facilitation as a high policy priority.

The overall quality of logistics services and supply chain efficiency is dependent on the quality of regulatory services (business facilitation) provided by the government. These include customs clearance, domestic indirect tax collection and processing, regulatory services related to the screening of health standards and the like, and local tax collection. Other government services include those provided by public sector airport authorities, ports, highways, and rail container movement. The critical policy questions are whether (a) India has a concrete plan in place to deal with the current challenges of trade and business facilitation, and (b) whether there is a longer-term plan to ready for new trends in manufacturing.

The Indian government needs to shift its focus immediately to trade and business facilitation reforms to boost trade as well as attract larger inflows of FDI. India with 250 million-plus middle-class consumers will get market-seeking FDI, i.e. investment that seeks to serve its domestic consumers irrespective of business environment. But the crux of becoming competitive and creating the extra millions of jobs that India desperately requires lies in attracting efficiency-seeking FDI, or investment that uses India as a manufacturing base for global production and innovation. Such FDI would integrate Indian entrepreneurs into the global market by exposing them to the best technologies, marketing networks, and management systems.

The critical elements of policy required to integrate into the global supply chain are (a) relatively low tariffs (to allow easy importation of intermediates), and a simplified tariff structure, (b) regulatory environment that is attractive to FDI in manufacturing, (c) a taxation system that ensures that no domestic taxes are exported ("zero-rating" of exports), (d) an environment of low transaction costs of operating across borders, and (e) strong logistical linkages, especially with regional economies. India does not have comprehensive reform initiatives in place to achieve any of these. A basic policy objective to integrate into regional production chains in Southeast Asia should be to bring Indian applied tariff levels down to the levels achieved by major economies there (from 14 per cent to 9 per cent).

As for domestic taxes, it is obvious that if their added cost is passed on to the price of the exported product it will make such products less attractive for procurement within a price-sensitive global supply chain. One long-standing demand of Indian exporters has been the implementation of the long overdue comprehensive goods and services tax. A related demand has been the removal of all state and local taxes that are not rebated to exporters to ensure complete zero-rating of exports in terms of domestic taxes.

Simultaneously, we need to urgently push the remaining trade facilitation reforms which were outlined in the 2004 report to the finance ministry of its working group on trade facilitation, which I chaired. The key recommendations were:

1. To rely on a system based on trust, with self-certification of importers, ex-post audits, and minimal physical inspection;
    
2. Speedy clearance with a state-of-the art risk management system
    
3. Full automation leading to a paperless system with minimum face-face-contacts and signatures
    
4. Cargo dwell time reduced to levels comparable to the best performers in Southeast Asia
    
5. And most importantly, quarterly monitoring of cargo-dwell time in major ports and airports by a high-level inter-ministerial committee with the full attention of the prime minister.

In addition, a comprehensive programme to reduce the cost of movement of goods behind the borders from hinterland to ports needs to be undertaken. Its primary goal would be to identify the regulatory bottlenecks to fast and efficient cargo movement within India and their rectification. This would need the full participation of ministries, state governments, and the private sector, and would thus require considerable political support. The regulatory bottlenecks holding up development of ports, coastal shipping, and air cargo should also be addressed.

India does not have the luxury of time. Supply-chain efficiency is critical to manufacturing competitiveness in the present scenario, of mass production largely in large-scale assembly line production systems that have remained more or less un-changed since the early 20th century. But rapid changes fuelled by technology and shifting consumer preferences and behaviour are going to bring some very significant changes in how manufacturing is organised and managed. Some of these trends are already visible in the growth of greater customisation of both final as well as intermediate goods and the use of e-commerce platforms. Such shifts in how global production systems are organised are already seeing India's competitors making huge investments in logistics and trade facilitation. India risks being left behind, and thus the time for logistics, trade and business facilitation is now!

The writer, a trade economist, was economic adviser to the ministry of commerce.
To be continued next Sunday